Streetwise Professor

April 10, 2009

So Close to Russia, So Far From God: A Reprise

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 12:30 pm

Turkmenistan’s foreign ministry issued an exceedingly blunt statement blaming Gazprom for an explosion in a Turkmen gas pipeline.  The explosion allegedly followed an unexpected curtailment of Russian imports of Turkmen gas:

Turkmenistan, however, in a burst of undiplomatic language, blamed Russia for the pipeline disruption, saying Russia’s gas export monopoly Gazprom (GAZP.MM) had “irresponsibly” cut imports of gas and caused the accident.

The undiplomatic diplomatic response:

Turkmenistan’s foreign ministry said in a statement Gazprom cut gas imports on April 8 without warning its government in the capital of Ashgabat.

“Such actions by Gazprom Export are ill considered and irresponsible because it created a real threat to peoples’ lives and health and can lead to unpredictable ecological consequences,” the ministry said.

“Such an approach (low gas imports) is a unilateral, rude violation of the terms of the take-or-pay gas supply contract,” the ministry said in an unusually harsh statement. Gazprom is a state controlled firm and Turkmenistan has repeatedly called Moscow one of its most important strategic partners.

Now, let’s take our minds back to the dark, distant past; like, say, March, 2009.  Can anybody remember the bleating from Putin and Gazprom about how unacceptable it was for Ukraine and Europe to take unilateral actions in gas transportation without consulting with, or considering the interests of, the supplier of the gas?  I knew you could.  If Ashgabat is to be even partly believed, Russian took unilateral action  that caused a serious accident  without consulting the supplier of gas.  Kremlin/White House whinges about respecting their rights/interests would be less nauseating if they kept their hypocrisy somewhat in check, rather than giving it full, neurotic, narcissistic play at every opportunity.   (I acknowledge that anything coming from the Ex-Sov space needs to be taken with a dose of skepticism, but since Gazprom/Putin are among the world’s most brazen liars, Turkmenistan wins my vote on the relative credibility scale here.)  

So why would the Russians cut imports of Turkmen gas?  One hypothesis is that it is payback for Turkmenistan’s audacity in issuing an international tender for a new gas export pipeline–a pipeline that Gazprom had assumed it would build:

Russia began a “gas war” with Turkmenistan after the Central Asian nation called an international tender last week to build a pipeline, hurting relations as  OAO Gazprom  expected the contract, Kommersant said.

The tender for the East-West link from the biggest gas field in the Commonwealth of Independent States came as a surprise for Russia, the Moscow-based newspaper said.

Turkmenistan accused Gazprom of causing an explosion on a pipeline to Russia via Uzbekistan yesterday by reducing supply “sharply.” The country had exported 70 million to 80 million cubic meters of gas a day via the link before the blast cut shipments completely, Kommersant said.

I have another hypothesis.  Gazprom is sucking wind, and badly.  To mix medical metaphors, it is hemorrhaging cash, and those problems will only get worse in the coming quarters as the lagged adjustment in gas export prices will drastically cut the price Gazprom gets for its sales to Europe, and as volumes decline as well due to seasonal factors and the severe economic downturn in Europe.  

And here’s the major point.  The company also outsmarted itself by buying large quantities of Turkmen gas at  fixed prices that seemed like a good idea at the time, but which retrospectively turned out to be far above the current market price, and likely prices going forward.  (It’s a bitch being long flat price and short floating price in a bearish environment.  But schadenfreude is so sweet when Gazprom is involved!)  Note the Turkmenistan foreign ministry statement explicitly mentions “take-or-pay” contracts–this means that Gazprom was contractually obligated to take the full volume at the above market price, even if it had no market for the gas.  

So, one reasonable hypothesis is that a cash-strapped Gazprom probably tried to get Turkmenistan to give it a break on the take-or-pay obligations; Turkmenistan told Gazprom to pound sand; and Gazprom/Russia decided to welsh on the contract, unilaterally cutting its acceptance of deliveries.  Any pique over the Turkmenistan’s temerity at acting as an independent nation rather than a satrapy of Gazprom/Russia just provided another motive for Gazprom to stiff/punish the Turkmen.

Keep this episode in mind the next time Gazprom/Putin/Medvedev/Russia mention anything having the remotest connection with commercial morality or professionalism.  

The best thing about this is that it suggests that Turkmenistan is actually showing backbone and standing up–in a very public, in-your-face sort of way–to Gazprom and Russia.  There is an opportunity here.  I just wonder if anybody in DC (Foggy Bottom in particular) or Brussels is smart enough to take advantage of it.

The second best thing is that it provides evidence that Gazprom is under intense financial pressure.  And if Gazprom is under intense financial pressure, so are Putin and the rest of the coterie of parasitic capos that feast off it.

April 9, 2009

Sergei Lavrov, Lying Through His Teeth

Filed under: Military,Politics,Russia — The Professor @ 1:05 pm

Russian Foreign Minister Sergei Lavrov is apparently in a competition with Igor Sechin for the title of Mr. Mendacious.   Lavrov is obviously a proud graduate of the Molotov-Gromyko School of Foreign Relations.

First, Lavrov “warns against haste in North Korea“:

Russian Foreign Minister Sergei Lavrov urged countries not to jump to conclusions about North Korea’s weekend rocket launch, according to Russia’s Interfax news agency on Tuesday.

“We must avoid any hasty conclusions. Clearly this situation does not cause joy, it causes our concern. We would like to have a clear understanding of all details,” Lavrov was quoted as saying at a Moscow press conference.

Sure!   What’s the hurry?   We really need more time to understand all the details.   What the hell, this is only the latest chapter in a saga running since 1993, with major developments in 1994, 2006, and 2007.   We obviously haven’t had enough time, a mere 16 years, to comprehend what is going on here.   So let’s just give Lil’ Kim more time to perfect his ICBMs and nukes while the slow learners buy a clue.

C’mon Sergei.   Blackmail by a crazed, bankrupt regime ain’t that hard to understand.   But we know you understand.   You’re just playing dumb.   The fact is that you find turmoil very convenient for your revisionist, revanchist foreign policy.   Turmoil not just involving the NoKos, but Iran and other regions as well.   So you have no interest in mitigating this turmoil.   Quite to the contrary.   Keeping the various pots boiling is quite useful to you.

Item two: “Russia Warns US Against Competition for Allies“:

Russian Foreign Minister Sergei Lavrov said the United States and Russia should not force former Soviet republics to choose between an alliance with Washington and Moscow, RIA news agency reported on Thursday.

In remarks which appeared to refer to political disturbances in ex-Soviet Moldova, Lavrov said there should be no “hidden agendas” in relations between the United States and Russia.

“It is inadmissible to try to place a false choice before them — either you are with us or against us — otherwise this will lead to a whole struggle for spheres of influence,” Lavrov was quoted as saying by the agency.

Lavrov denied Russia was seeking to build spheres of influence and said it was inappropriate to compare the violence in Moldova with protest movements that brought new leaders to power in other former Soviet republics such as Ukraine, Georgia and Kyrgyzstan.

He said Russia had been disturbed by the events in Moldova and called on the European Union and NATO member Romania to ensure Moldovan statehood was not undermined by people waving Romanian flags.

OMG!   Waving Romanian flags!   Oh, the humanity!

“Lavrov denied Russia was seeking to build spheres of influence.”   Tell me another one.   And, by the way, consult with your (official, anyways) boss, President Medvedev, who last year clearly stated that Russia had “privileged interests.”   He obviously meant that Russia intended to assert spheres of influence in the “near abroad.”   Everyone understood him to mean as much.   He never denied these interpretations.

Moreover, let’s look at the walk, not the talk.   Whether it is the Caucusus, Central Asia, or Ukraine and Moldova, Russia is clearly using both force and bribery to prevent nations in these regions from getting close to the US.

Russia, as it never ceases telling us, is a sovereign nation.   It can make its own foreign policy choices.   But spare us, please, the Orwellian Sov-speak of denying the blindingly obvious.

April 8, 2009

Captivating II

Filed under: Financial crisis,Politics — The Professor @ 9:07 pm

Willem Buiter weighs in the regulatory capture theme:

Governments everywhere are doing the best they can to delay or prevent the lifting of the veil of uncertainty and disinformation that most banks have cast over their battered balance sheets. The   banking establishment and the financial establishment representing the beneficial owners of the institutions exposed to the banks as unsecured creditors – pension funds, insurance companies, other banks, foreign investors including sovereign wealth funds – have captured the key governments, their central banks, their regulators, supervisors and accounting standard setters to a degree never seen before.

I used to believe this state capture took the form of  cognitive capture, rather than  financial capture.   I still believe this to be the case for many, perhaps even most of the policy makers and officials involved, but it is becoming increasingly hard to deny the possibility that the extraordinary reluctance of our governments to force the unsecured creditors (and any remaining non-government shareholders) of the zombie banks to absorb the losses made by these banks, may be due to rather more primal forms of state capture.

Like me, Buiter is concerned about Fed independence and credibility:

sible way from the point of view of medium- and longer-term economic performance, by surrendering central bank independence to the fiscal authorities.

When the Fed lends on a non-recourse basis to the private sector with only a $100 bn Treasury guarantee for a possible $1 trillion dollar Fed exposure (as with the TALF),   when the Fed purchases private securities outright with just a similar 10-cents-on-the-dollar Treasury guarantee or when the Fed is party to an arrangement that transfers tens of billions of dollars to AIG counterparties – money that is likely to be extracted ultimately from the beneficiaries of other public spending programmes or from the tax payer, either through explicit taxes or through the inflation tax – the Fed is acting like an off-balance sheet and off-budget special purpose vehicle of the US Treasury.

When the Chairman of the Fed stands shoulder-to-shoulder or sits side-by-side with the US Treasury Secretary to urge the passing of various budgetary proposals – involving matters both beyond the Fed’s mandate and remit and beyond its competence – the Fed is politicised irretrievably.   It becomes a partisan political player.   This is likely to impair its ability to pursue its monetary policy mandate in the medium and long term.  

The bottom line?  Another SWP mantra:

But with the banking system on its uppers and many key financial markets still disfunctional and out of commission, external financing will be scarce and costly.   This is why sorting out the banks, or rather sorting out the substantive economic activities of new bank lending and funding, that is, sorting out  banking  , must be a top priority and a top claimant on scarce public resources.

Until the authorities are ready to draw a clear line between the  existing banks  in western Europe and the USA, – many or even most of which are surplus to requirements and have become parasitic entities feeding off the tax payer – and the  substantive economic activity  of bank lending to non-financial enterprises and households, there will not be a robust, sustained recovery.

But with the regulators and legislators captured, cognitively, primally, or otherwise, the line is not being drawn.  And hence, “a robust, sustained recovery” is not in the offing.

The compromising of Fed independence and credibility; ballooning, unprecedented fiscal deficits that will be financed either by inflation, or by higher income taxes; and a chronically ill banking system operating under dysfunctional incentives enabled by arguably captive governments is a recipe for prolonged stagnation/stagflation.  The fact that the Fed and Treasury are also fighting against the equilibration of the economy, by propping up sectors of the economy that should contract, only aggravates these problems.  A Lost Decade looms.

April 7, 2009

Will This Make Certain SWP Readers Revise Their Bet?

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 9:51 pm

Michel and DR have a bet on the performance of the Russian economy in 2009.  I’m Shocked! Shocked! to see gambling at Craig’s Cafe SWP!

Russia Economy Watch has a very thorough description analysis of the subject of the bet.  Some highlights (lowlights?):

According to Deputy Economic Development Minister Andrei Klepach last week, Russia’s economy shrank by 7 percent year on year in the first quarter of 2009, a staggering turnaround for an economy which has just enjoyed eight years of solid oil-fueled growth.

“These figures are worse than we expected,” Klepach said at a press conference in Kiev,citing preliminary figures. Klepach also stated that net capital outflows reached $33 billion in the first quarter of 2009, following record outflows of $130 billion in the second half of last year.

. . . .

The Russian State Statistics Service have also released official gross domestic product figures for the fourth quarter of 2008. GDP was up 1.2 percent year on year, the worst reading for any quarter since the first quarter of 1999, and down from a revised 6 percent in the previous three months. The World bank are now suggesting that the present slump may be deeper than the one that followed the government debt default and ruble devaluation in 1998.

Certainly the data are bleak. Industrial production contracted for a fourth consecutive month in February – falling by 13.2% year on year – as the credit squeeze and falling incomes eroded demand for metals, cars and consumer goods. Retail sales contracted in February for the first time since February 1999. Unemployment was also up, at 8.5 percent in February, the highest level since January 2005.

Manufacturing output plunged with the collapse in demand in the last two months of 2008, and it is likely to contract further in 2009. According to Rosstat five of 14 major manufacturing industries reported outright output declines in 2008, with electronics, electrical, and optical equipment hardest hit (-7.9 percent), followed by textile and sewing (-4.5 percent) and by chemicals (-4.2 percent). Most of the dislocation took place in November and December 2008, when total manufacturing output respectively fell 10.3 and 13.2 percent (year-on-year). As credit continues to tighten and demand to fall, manufacturing is likely to contract further in 2009. According to recent statistics, manufacturing output dropped 24.1 percent in January 2009, compared with January 2008, and 18.3 percent in February 2009, compared with February 2008. In February 2009 the most significant declines were registered in the production of electro-technical and optical equipment (-46.6%), other non-metal products (-33.3%), and transport and transportation equipment (-31%).

. . . .
The latest data we have to hand confirm the ongoing character of the contraction. The Russian economy is thought to have declined by 5.4 percent in March compared with March 2008, according to the latest GDP indicator estimate provided by VTB Capital. The VTB GDP indicator also registered an average 4.4 percent contraction for the first three months of 2009, which would be the worst decline since the economy shrank 5.1 percent in the fourth quarter of 1998. The difference between the VTB estimate and the 7% estimate put forward by Klepach would lie in the fact that the VTB indicator does not include contstruction, and construction activity has declined sharply in recent months, so the two pieces of data are consistent with one another.

. . . .

As a result of this contraction in output and weakening in the labour market real incomes have declined substantially in Russia since the autumn of 2008. Rising unemployment and worsening enterprise finances (wage arrears have increased considerably) have meant that in the fourth quarter of 2008 alone, real disposable income dropped 5.8 percent year on year, and by 10.2 percent in January 2009 (again year-on-year). And unpaid wages as a share of total enterprise turnover tripled to 0.12 percent in December 2008, compared with August 2008. The stock of wage arrears as of March 1, 2009 (8 billion rubles or about USD 240 million) remains small but is likely to increase as the crisis grows. At the present time such arrears are thought to affect up to 450,000 people, significantly less than 1 percent of total employment. Growth in real wages came to a complete halt in January-February 2009, following double-digit increases in previous years.

. . . .

Inflation was spurred at the start of the year by the weakening ruble, which pushed up import prices, helping the annual rate jump to 13.9 percent in February from 13.4 the month before. The ruble has now lost 29 percent against the dollar since August. The most recent spike in inflation is evidently producing quite a headache for the Central Bank, since chairman Sergei Ignatiev last week that if April’s inflation is “significantly less” than it was a year ago, the central bank may consider cutting interest rates for the first time since 2007, giving some kind of monetary relief to an economy which is badly in need of it. Russia’s inflation rate went as high as 15.1 percent last June, and has since come down somewhat from that peak, but really the record of the central bank in containing inflation has been pretty abysmal.

Bank Rossii has been forced to raise its refinancing rate twice since last November, to the current level of 13 percent, in an attempt to limit the amount of rubles available to banks and companies and to slow the decline of the ruble against the dollar. On the other hand the central bank may be in danger of excessive optimism at this point, with Ignatiev telling journalists that his expectation was that the economy may pick up within “several months,” thus trying to offer hope that Russia’s banks won’t suffer that “second wave” of crisis that Finance Minister Alexei Kudrin said may hit as bad loans eat up capital. I am of the opinion that Kudrin is right to be cautious here.

Rising delinquency “is a serious problem, but I don’t share the opinion that a second phase of the crisis is unavoidable,” is Ignatiev’s view. Overdue retail loans rose to 4.4 percent as of 1 March from 3.2 percent on 1 September. “I believe the most serious phase of the economic crisis is over,” Ignatiev told journalists. Would that he were right, unfortunately I think he is wrong, the worst is still ahead.

Obviously the continuing inflation is a problem for Russia’s central bank since they would obviously like to offer monetary easing to the economy, just as the U.S. Federal Reserve, the European Central Bank and the Bank of England are doing by bringing their benchmark rates close to zero to bolster banks and pull their economies out of recessions. Bank Rossii last cut the refinancing rate in June 2007, and it has now increased the repurchase rate charged on central bank loans four times since November.

REW does note that various measures indicate that the rate of contraction in the Russian economy slowed in March; the economy was still contracting, but not as rapidly as in February, which in turn exhibited a lower rate of contraction than January.

To me, the most interesting aspect of all this is the policy dilemma.  The inflation issue mentioned above is a serious issue.  As I’ve mentioned before, Russia is in a stagflationary situation, which makes it very difficult to use an expansive monetary policy.  (Not that I think that US or UK policy is to be emulated.  We’re just facing a stagflation down the road.)  

A more severe contraction than forecast by the government also puts Russian government finances in a serious bind:

While the Organization for Economic Cooperation and Development and the World Bank are forecasting that the Russian economy will decline by 5.6 percent and a 4.5 percent, respectively, in 2009, the Russian government is still stubbornly holding fast to its official forecast of a 2.2 percent fall. Publicly government officials are sticking to their view, and diiging in around the idea that they expect a recovery in the final quarter. Deputy Economic Development Minister Klepach said that the government forecast takes into account a package of anti-crisis measures currently being debated by lawmakers that should bolster domestic demand and help boost GDP. Without it, the economy could contract by 4 percent to 5 percent, Klepach noted.

The Central Bank, on the other hand, continues to forecast a 4.5 percent contraction for the current year.

The Russian Cabinet approved last month a revised budget containing the first deficit in 10 years. The budget anticipates a deficit of 7.4 percent of projected gross domestic product, but since the current forecast is for a GDP contraction of only 2.2%, the final deficit may be considerably larger. The Finance Ministry is now transfering money from the Reserve Fund to cover the deficit, and anticipates using some 2.7 trillion rubles this year to help fund the budget gap.  

The Ministry of Finance has released the main parameters of its revised federal budget for 2009 which is based on lower oil prices (USD 41 a barrel, Urals) and a drop in budget revenues from the original 21.2 percent of GDP (under the old assumption of USD 95 a barrel) to 16.6 percent, or RUB 6.72 trillion. At the same time, expenditures will be increased by RUB 667.3 billion to RUB 9.69 trillion, to produce a deficit of RUB 2.98 trillion (about 7.4 percent of GDP), a massive reversal of the fiscal position from the 4.1 percent surplus in 2008.  

The total consolidated general government deficit is expected to be around 8 percent in 2009 deficit and will be financed largely from the Reserve Fund (7 percent of GDP) with modest domestic borrowing (up to 1 percent of GDP). With a large fiscal deficit, however, and the need to preserve some reserve fund resources for the uncertainty likely to extend into 2010, the space for more fiscal stimulus this year appears limited.

So the level of the contraction which the Russian economy undergoes in 2009 really is rather big beer, since it will condition the size of the eventual fiscal deficit, and the percentage of the Reserve Fund which will need to be used this year. If there is no rebound in oil prices in 2010 then Russia’s position can complicate on a number of fronts, since the Central Bank Reserves will be significantly depleted, the Reserve fund also, and there may be less room for fiscal easing in the face of potential credit rating downgrades, while monetary easing may also prove difficult given the need to support the currency, and protect Central Bank Reserves. All in all, 2010 could be a very hard year for Russia and its citizens.

Putin is touting the efficacy of his fiscal policy measures;

Prime Minister Vladimir Putin defended his handling of Russia’s economic crisis on Monday, telling lawmakers a 3 trillion-rouble ($90 billion) aid package would ensure the country survived a “very difficult 2009”.

“What should — and must — be said with all certainty is that Russia will overcome the crisis,” a confident Putin said in a 65-minute report to the State Duma (lower house), his first as prime minister.

“The country will beyond all doubt keep its position as one of the largest economies of the world.”

Amazingly, Putin also forecast that inflation would fall soon.  Right.  

I think a more realistic appraisal is that the likely prolonged economic downturn will put tremendous pressure on the Russian budget, thus draining the reserve funds, and putting tremendous pressure on the Central Bank to inflate.  

Russia’s fate depends now, more than ever, on a worldwide recovery.  Russia is a high beta country, due to its dependence on raw material exports.  The US Fed’s unprecedented loose monetary policy may also provide help to Russia by helping to prop up the prices of Russian exports.  But Russian policymakers have very few levers to pull.  They are at the mercy of the world economy.  And therefore, so are the betting men on SWP;-)


Filed under: Economics,Financial crisis,Politics — The Professor @ 8:27 pm

If sometimes I seem a little, well, schizo, there’s a reason for that.  On the one hand (or is it personality?), I have deep Hamiltonian sympathies for commerce and industry.  Moreover, I share Hamilton’s view that finance is an essential complement to commercial and manufacturing activities, facilitating as it does the efficient allocation of resources over time and risk across individuals.  On the other hand/personality, I have strong Jacksonian instincts, with a suspicion of big government, and a healthy skepticism (if not Jacksonian hate) for large banks.

The contradiction is more apparent than real, and can be largely eliminated by an appeal to Adam Smith, via Friedman and Stigler.  As these gentlemen often pointed out, Adam Smith was a firm believer in what later came to be called capitalism, but he was deeply hostile to individual capitalists.  Smith was especially critical of large business interests’ exercise of political power to induce the government to extend them favorable privileges or trade protections.  Stigler and his followers subsequently built on Smith’s insight to argue that large, concentrated interests, especially business interests, could effectively “capture” legislators and regulators, thereby securing favorable laws and regulatory decisions.  One can therefore quite consistently be a Hamiltonian supporter of commerce, industry and finance, and a Jacksonian critic of the powers and privileges that commercial, industrial, and financial firms secure through their influence on, and perhaps capture of, the government.

This issue is of direct relevance to the financial crisis, and policy responses thereto.  In a long piece in the Atlantic, former IMF chief economist and current MIT professor Simon Johnson argues “that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises.”  

I am not particularly convinced by Johnson’s argument that capture of the government by large financial institutions led to the adoption of policies that caused the crisis.  I do agree, however, that the baleful political influence of large financial institutions is impeding the resolution of that crisis, and threatens to prolong and deepen it.  

Johnson presents a list of regulatory and legislative developments in the 90s and 00s, and suggests that these various moves to free finance from legal fetters caused the crisis:

From this confluence of campaign finance, personal connections, and ideology there flowed, in just the past decade, a river of deregulatory policies that is, in hindsight, astonishing:

• insistence on free movement of capital across borders;

• the repeal of Depression-era regulations separating commercial and investment banking;

• a congressional ban on the regulation of credit-default swaps;

• major increases in the amount of leverage allowed to investment banks;

• a light (dare I say  invisible?) hand at the Securities and Exchange Commission in its regulatory enforcement;

• an international agreement to allow banks to measure their own riskiness;

• and an intentional failure to update regulations so as to keep up with the tremendous pace of financial innovation.

The mood that accompanied these measures in Washington seemed to swing between nonchalance and outright celebration: finance unleashed, it was thought, would continue to propel the economy to greater heights.

I agree that the changes were indeed astonishing.  Some were clearly salutary (e.g., free capital flows).  Most others, (e.g., the repeal of Glass-Steagall, the Commodity Futures Modernization Act that limited–but did not eliminate, as is often asserted–regulation of OTC derivatives) contributed little if anything, in my view, to the coming of the financial crisis or its severity.  One-“an international agreement to allow banks to measure their own riskiness”–is onto something, but not primarily for the reason that Johnson highlights.  The Basel II banking regulations engendered massive efforts to move banking activities, and risk, off balance sheet, and thereby encouraged some pernicious financial engineering driven primarily by regulatory arbitrage/avoidance, rather than legitimate reasons of risk allocation.  A good example of the law of unintended consequences to keep in mind when someone glibly recommends bank capital regulation reform as a magic bullet.

Regardless of whether Johnson or I am correct, that’s water over the damn now.  What is of the moment is where do we go from here.  And in this area, I am largely in agreement with Johnson’s diagnosis that many policymakers are captured by large financial institutions; that the interests of these large financial institutions, their managers and their shareholders, are not aligned with the interests of the rest of us; and that as a result of the conjunction of these two factors, policies to address the financial crisis are dangerously off track and threaten even greater damage.  

Johnson’s analysis agrees with that which I have offered here on SWP, with respect to (a) the great dangers of allowing insolvent or nearly insolvent banks to remain in operation in such a parlous financial condition; (b) the very strong incentive of such banks to continue to operate in hopes that luck or insane gambles will restore them to solvency; and (c) the apparent success of these banks in shaping policies that have given them an unwarranted lease on life, and perpetuated their perverse operational incentives:

This latest plan—which is likely to provide cheap loans to hedge funds and others so that they can buy distressed bank assets at relatively high prices—has been heavily influenced by the financial sector, and Treasury has made no secret of that. As Neel Kashkari, a senior Treasury official under both Henry Paulson and Tim Geithner (and a Goldman alum) told Congress in March, “We had received inbound unsolicited proposals from people in the private sector saying, ‘We have capital on the sidelines; we want to go after [distressed bank] assets.'” And the plan lets them do just that: “By marrying government capital—taxpayer capital—with private-sector capital and providing financing, you can enable those investors to then go after those assets at a price that makes sense for the investors and at a price that makes sense for the banks.” Kashkari didn’t mention anything about what makes sense for the third group involved: the taxpayers.

Even leaving aside fairness to taxpayers, the government’s velvet-glove approach with the banks is deeply troubling, for one simple reason: it is inadequate to change the behavior of a financial sector accustomed to doing business on its own terms, at a time when that behavior  must  change. As an unnamed senior bank official  said to  The New York Times  last fall, “It doesn’t matter how much Hank Paulson gives us, no one is going to lend a nickel until the economy turns.” But there’s the rub: the economy can’t recover until the banks are healthy and willing to lend.

The Way Out

Looking just at the financial crisis (and leaving aside some problems of the larger economy), we face at least two major, interrelated problems. The first is a desperately ill banking sector that threatens to choke off any incipient recovery that the fiscal stimulus might generate. The second is a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support.

Big banks, it seems, have only gained political strength since the crisis began. And this is not surprising. With the financial system so fragile, the damage that a major bank failure could cause—Lehman was small relative to Citigroup or Bank of America—is much greater than it would be during ordinary times. The banks have been exploiting this fear as they wring favorable deals out of Washington. Bank of America obtained its second bailout package (in January) after warning the government that it might not be able to go through with the acquisition of Merrill Lynch, a prospect that Treasury did not want to consider.

The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize troubled banks and break them up as necessary.

In some ways, of course, the government has already taken control of the banking system. It has essentially guaranteed the liabilities of the biggest banks, and it is their only plausible source of capital today. Meanwhile, the Federal Reserve has taken on a major role in providing credit to the economy—the function that the private banking sector is supposed to be performing, but isn’t. Yet there are limits to what the Fed can do on its own; consumers and businesses are still dependent on banks that lack the balance sheets and the incentives to make the loans the economy needs, and the government has no real control over who runs the banks, or over what they do.

At the root of the banks’ problems are the large losses they have undoubtedly taken on their securities and loan portfolios. But they don’t want to recognize the full extent of their losses, because that would likely expose them as insolvent. So they talk down the problem, and ask for handouts that aren’t enough to make them healthy (again, they can’t reveal the size of the handouts that would be necessary for that), but are enough to keep them upright a little longer. This behavior is corrosive: unhealthy banks either don’t lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won’t pay off at all. In either case, the economy suffers further, and as it does, bank assets themselves continue to deteriorate—creating a highly destructive vicious cycle.  

The fundamental problem is that insolvent banks face very perverse incentives, and as a result (a) tend to dissipate wealth rather than build it, and (b) banking problems tend to metastasize, with persistent, pernicious effects on the broader economy.  There are a variety of approaches to address this problem.  Johnson advocates nationalization.  Others advocate variants on the good bank-bad bank approach. I’ve added the Humpty-Dumpty twist to the good bank-bad bank alternative.  Although these approaches differ in detail, they all involve some common elements, most notably isolating bad assets, and forcing the restructuring of insolvent institutions (whose insolvency is typically revealed only after the full extent of their bad asset holdings is recognized by stripping out these assets).  This restructuring typically wipes out shareholders, leads to the departure of top management, and can also impose losses on debtholders.  That is, it forces the claimants of insolvent banks, and the holders of their residual control rights, to internalize the costs of insolvency.  Banks shareholders, bondholders, and managers, however, have every incentive to try to externalize those costs.  The gambling to survive option is the most effective way to do that, and that is precisely why recent policy changes, including many features of the Geithner plan, and the recent FASB rule change on accounting for some assets, are so troublesome: these policies enable insolvent banks to extend their lives, and indulge their bad incentives for who knows how much longer, and at what cost.  

As I wrote last week, there are some rumblings from within the administration that suggest that the capture is not complete.  In particular, statements that banks would be forced to write down assets, or to sell them into the Geithner bad loan and bad securities programs, give reason to believe that the administration is aware of the perverse incentives inherent in the black-and-white of the Treasury plan, and intends to take away with regulatory pressure the options that the Treasury blueprint and the new accounting rules have given.  

But that is just a conjecture, and one that gives the administration the benefit of the doubt.  Actions speak louder than words.   Until the banks squeal very loudly that they are being driven to the wall by Treasury or FDIC dictates to sell bad assets, thereby revealing to all the extent of their financial position (insolvent or no?), I will continue to believe, along with Simon Johnson, in the literal words of the Treasury plan.  Those words give tremendous discretion to banks with bad incentives.  That screams capture, and bodes ill for the future.

And even if the Treasury and Fed and FDIC are truly being Machiavellian, taking away through left-handed pressure the optionality that Treasury extended with the right hand of the PPIPs program, it would be much more comforting if it acted in a straight-forward manner.  It would provide a stronger signal that they are in fact not prisoners of the bad banks.  And what’s more, due to their political power and influence, it is quite possible that they will be able to deflect, if not defeat altogether, pressure that the government attempts to bring to bear.  

This should give pause to those that view “more regulation” as a mantra that will fix all of our problems.  That is a dreamy vision of regulation, that works in Nirvana, but not here on earth.  On earth, individuals and firms with large sums at stake and superior information almost invariably shape regulation to their benefit.  Both conditions hold in banking today, and given the complexity of modern financial institutions and the products they trade, the informational advantages of the banks over legislators, let alone the GS 12s, 13s, and 14s expected to bring them to heel, are immense.  It is wildly optimistic to expect that the normal operations of politics and regulation will lead to an outcome that is not far too beneficial for banks, their shareholders, their bondholders, and their executives.

That is, the problem is an economic one, but its solution is at heart a political one.

And maybe that brings us back to Andrew Jackson.  Jackson exerted enormous political power to undermine the Second Bank of the United States, an institution that had been associated with (believe it or not) extremely lax credit policies that fed a speculative land boom and endemic corruption.  The deeply libertarian Jackson believed that the BUS was a threat to both the economy, and American political liberty.  He prevailed in a titanic political struggle against Nicholas Biddle (the bank’s president), Henry Clay, and Daniel Webster.  

Now, Jackson’s banking policy as a hole was hardly admirable, but his actions do indicate that capture is not inevitable.  But there is room for considerable doubt whether anything remotely Jacksonian is likely to come out of Washington today.  Which means that the regulatory capture that Simon Johnson laments may be with us for a long time, with baleful consequences.

April 6, 2009


Filed under: Economics,Financial crisis,Politics — The Professor @ 8:53 pm

I’ve mentioned several times that I have invested in Treasury Inflation Protected Securities, or TIPS, due to my serious concern that inflation is a major threat given the Fed’s vast expansion of base money.*  That idea is apparently going mainstream, with many big “real money” managers taking the same position:

At  BlackRock Inc., Vanguard Group Inc.,  Pacific Investment Management Co.and Pictet & Cie Banquiers, concerns are growing that policy makers will struggle to control inflation once economies start to recover. The Federal Reserve, Bank of England and European Central Bank have increased money supply by an average 9.2 percent in the past year, or the equivalent of $2 trillion, to $24 trillion, according to the broadest measure each uses.

. . . .

“Inflation worldwide is going to surge in the years to come,” said  Mickael Benhaim, who manages about $32 billion as head of global bonds at  Pictet  in Geneva. “On the supply side, issuance of the securities as a ratio of overall government debt is sharply declining,” which “makes linkers look very attractive,” he said.

Benhaim says there’s a shortage of inflation-linked debt in the U.K. too. There are about 180 billion pounds ($266 billion) of index-linked gilts outstanding, or 23 percent of the total debt, down from 30 percent a year ago, U.K. Debt Management Office data show.

In the euro region, where the ECB targets an inflation rate of just under 2 percent, the market totals about 250 billion euros ($336 billion), or 7 percent of all outstanding debt, down from 7.2 percent a year ago.

TIPS Cheapest

BlackRock‘s Weinstein said TIPS are the cheapest inflation- linked bonds. Notes maturing in one, two and three years have the smallest breakeven rates outside Japan, where deflation expectations persist through 2010’s first quarter, according to the median response in a Bloomberg survey of 16 economists.

“On a  relative value  basis, the U.S. inflation market is the one I would rather  own,” Weinstein said. “If I could sell U.K. breakevens and European breakevens and buy U.S. breakevens, I would.”

Of course, not everybody has a clue:

“Inflation is driven historically by wages, and clearly if you have the unemployment rate rising, it begs the question where will you get inflation from,” said  Chris Lupoli, executive director for global inflation-linked strategy at UBS AG in London. “We’re projecting that there will be a global healing but that the recovery will be anemic.”

Uhm, Chris, the Phillips Curve died like, you know, 30 years ago.  Heard of stagflation?  It is possible to have both high unemployment and high inflation.  

I have repeatedly heard it said that the Fed has the tools to combat inflation when money demand/velocity picks back up again.  It can sell the securities it has bought to sop up the additional money it injected into the economy when it purchased them.

I have no doubt the Fed has the tools.  The question is: Does it have the will to use them?

I have very, very, serious doubts that its promises to fight inflation are credible.  Would the Fed really sharply increase interest rates when the economy is just recovering from a deep recession/depression, running the risk of aborting a resurgence of growth?  Is it likely that the Fed will sell large quantities of mortgage backed securities, potentially driving up mortgage rates and reducing housing prices, thereby risking another housing crash?  Will the Fed be able to resist the political pressure to monetize Obama’s huge deficits?  Moreover, the Fed’s involvement in the various bailout plans, its close cooperation with Treasury, and the rampant populism on the Hill, all raise the risk that the Fed’s independence has been compromised.  Given these factors, the risk of an unprecedented inflationary spurt is appreciable.

Or, to put it differently, in my view the only way we are likely to avoid a serious uptick in inflation is if the economy remains mired in near depression conditions.  I estimate that the odds of a non-inflationary recovery are very low.

I am not alone.  James Hamilton said it better than I could:

A second concern I have with the new Fed balance sheet is that it has seriously compromised the independence of the central bank. To my knowledge, every hyperinflation in history has had two key ingredients: (1) budget deficits that could not be resolved politically, and (2) a central bank that assumed the obligations that the fiscal authority could not.

In the U.S. today, there is little question in my mind that repaying the projected deficits with tax increases or spending cuts will be extremely difficult politically. Each additional trillion dollars would roughly require  doubling the personal income tax rate  on all Americans for one year, something I cannot see the political process delivering. There is enormous pressure in the current situation to defer solutions and look for temporary fixes with off-balance-sheet measures. The reason that the Fed is sought as a partner for the Treasury in all these new actions is because the Fed is perceived to have deeper pockets than the Treasury. This is not a situation that a self-respecting central bank should let itself get into.

My third concern is that the new Fed balance sheet has handicapped the Fed’s ability to fulfill its primary mission, which I see as promoting a stable and predictable low rate of inflation. Which of the Fed’s new assets would it sell off when it needs to  absorb back in  the huge volume of reserves it has recently created? The Fed’s hoped-for scenario is that the reserves won’t need to be called back in until the situation has stabilized and the facilities are no longer needed. But I am concerned instead about the possibility of a dramatic shift in the perceptions of foreign lenders, in which case inflationary pressures could emerge in a situation that is far more chaotic than the one we currently face.

I recommend instead that the Fed should be buying Treasury Inflation-Protected Securities in the current situation.  Tim Iacono  says that’s like the Mafia buying “protection” from itself. But my point is that TIPS represent an asset that would gain in value at a time the Fed needs to sell them, meaning that the logistical ability of the Fed to drain reserves quickly in such circumstances is without question.

What we need in the current situation is a central bank that is a bulwark of stability. A profound lack of confidence in the U.S. government itself would make our current problems look like a walk in the park. If the Fed had the means and the credibility to deliver a stable and low inflation rate, I believe that would go a long way to solving our current problems.

But it’s not clear the Fed has either the means or the credibility.

Not clear at all.

The potential for an inflationary outbreak is not bad news for everybody, though.  It is good for those long commodities, especially oil.  Indeed, the best hope for Russia, Iran, Venezuela, etc., is substantial dollar inflation.  An incredible Fed could be Putin’s best friend.  

* I do not offer investment advice.  Period.  I only mention this to indicate that I am putting my money where my mouth is.  

Today’s Congressional Comedy Break–The Energy Market Manipulation Routine

Filed under: Commodities,Derivatives,Economics,Energy,Politics — The Professor @ 7:37 pm

Last month Senator Maria Cantwell (Duh-W) announced two pieces of legislation to ”  help prevent future energy price bubbles and market manipulation“:

The first, S. 672, which she introduced on Mar. 24, would give the Federal Energy Regulatory Commission authority to issue cease-and-desist orders against manipulative schemes in progress. The US Securities and Exchange Commission and Commodity Futures Trading Commission already have this authority, she noted.

She said the bill also would make FERC able to freeze the assets of any entity suspected of market manipulation. It would give the commission authority to temporarily change or suspend power rates for up to 30 days during an energy emergency caused by market manipulation. And it would have any potential natural gas refund accrue from the time FERC brought a case (an approach currently used in electricity markets, according to Cantwell) instead of when it actually proves it.

“It will allow FERC to act more like a cop catching a robbery in progress instead of trying to piece together what happened at a crime scene after the fact,” she said.

Yes, we are expected to nod and trust the formulation of rules regarding the operation of our vast, and enormously complex financial markets to the likes of Senator Cantwell, who is apparently rather ill-informed about ordinary policing activities, let alone about the relevance of the possibility that cops may now and again interrupt an armed robbery at the Quickie Mart (Apu! Duck!) to the determination of the efficient way to reduce the frequency of manipulation and “excess speculation” in energy markets.  

First off, the premise of Cantwell’s analogy is wildly inaccurate.  Just how often do cops intervene while felonies are in progress?  Virtually all police work is done after the crime has been committed.  Cops respond to the calls of victims, or alarm calls, and in the vast majority of cases arrive after the perpetrators have fled.  Then begins the arduous process of “trying to piece together what happened at a crime scene after the fact.”  That’s exactly what cops spend most of their time doing.  Either Senator Cantwell watches way too much TV, or not enough.

Second, even if one were to grant that cops have the authority to intervene in crimes in process, and sometimes utilize that authority, that does NOT imply that this is the best way to fight market manipulation.  The law and economics of the trade-off of prevention vs. deterrence is very well understood.  (Steve Shavell wrote a very thorough article on the subject in the JLE in the early-90s.)  Deterrence–piecing together what happened after the fact, and imposing sanctions on those found to have committed harms–works best exactly in conditions like those that characterize a market manipulation.  Specifically, a real manipulation is readily detectable after the fact.  As Judge Easterbrook has written, “an undetected manipulation is an unsuccessful manipulation.”  Moreover, manipulators are typically not judgment proof.  That is, they are typically quite wealthy, and can afford to pay fines or other punishments equal to the harm they inflict.  Those that aren’t judgment proof are the firms whose manipulations failed spectacularly, and ruined the perps financially.  From a deterrence perspective, that isn’t a big deal, because fining successful manipulators can make the payoff to manipulation negative in every state of the world (fines when your manipulation succeeds; financial ruin when it doesn’t).  These are the conditions that make deterrence preferable to prevention.

Indeed, information considerations strongly favor ex post deterrence (as I argue in my 1996 book on manipulation).  Manipulations often unfold very quickly.  Moreover, the most distinctive effects of manipulation, such as the collapse in prices that follows the end of a corner (the “burying the corpse” effect), are virtually unmistakable after the fact, but cannot be observed while the corner is in progress. As a result of this fact, and others,  regulators necessarily have far less information about whether prices are distorted while a manipulation is in process, than after the fact.  Due to this information disadvantage, both “false positives” (intervening when a manipulation is not in reality occurring) and “false negatives” (failing to intervene in a real manipulation) are more likely when one attempts to act during an alleged manipulative event, than to wait and impose damaging sanctions after the manipulation is over.  Indeed, given that a mistaken intervention in a market would be extremely disruptive, false positive interventions are very costly.  That is, mistakes are much more likely, and the costs of mistakes are higher, when regulators attempt to intervene in real time, rather than to deter manipulation through the imposition of penalties.  (Moreover, private actions by those harmed by manipulation also have a strong deterrent effect, can rely on the superior information available after the fact, and can also fill the deterrence gap when regulators fail to act even after the end of a manipulation, as is too often the case.)  

Moreover, the costs of ex post deterrence only need be incurred when a manipulation has actually occurred, whereas maintaining a “police force” and surveilling every market is quite costly, and these costs must be incurred even when no manipulation is occurring.  

In other words, Cantwell is only 180 degrees off.  But it was one of her better days, I’m told.  

A couple of other entertaining thoughts.  First, the article states:

FERC would welcome this additional authority, according to one of the hearing’s witnesses, Anna Cochrane, acting director of the commission’s enforcement office. “Congressional action to give the commission cease-and-desist authority for violations of the [Federal Power Act] and [Natural Gas Act] and the ability to freeze assets of entities that violate the market manipulation rules would give the commission the same enforcement tools that both the SEC and CFTC have long possessed. In addition, authority to temporarily suspend market rules on file under the FPA when necessary to protect against potential abuse of market power could be useful,” she said in her written statement.

Imagine that.  A government agency that would “welcome . . . additional authority.”  Shocking.

Second, the article notes that CFTC and SEC have this authority.  With respect to market manipulation, it is seldom used.  

More humor:

Cantwell said the second legislation the hearing would examine would establish an office within EIA to collect and analyze information from physical and paper oil markets. This would improve EIA’s ability to predict future energy prices and help regulators police markets more effectively, she said.

In his written testimony, McCullough said no federal agency has been directed to investigate and explain last year’s extraordinary crude oil price changes despite oil’s arguably being the US economy’s most important commodity.

“The inability of the federal government to fully investigate oil price behavior in 2008 is fundamentally a data problem. Perhaps it is not a coincidence that oil is the most opaque of our nation’s energy supplies. The transparency legislation that you are discussing today is a step in the right direction because it will expand EIA’s ability to track oil inventories within the US by owner,” he said.

Sure.  EIA will be just dandy at forecasting energy prices.  And how is EIA, which has no enforcement authority, supposed to coordinate with CFTC and FERC (and perhaps soon, the FTC, when it puts its oil manipulation rule into effect), which do?  

“McCullough,” by the way, is Robert McCullough, Jr.  He is one of several people, e.g., Michael Masters, who routinely testifies before various House and Senate committees on energy market speculation and manipulation issues, and just as routinely parrots exactly what Cantwell, et al, want to hear.  The regular presence of this tiresome cast of courtiers, who IMO have little if any demonstrated expertise, and who routinely make idiotic arguments unsupported by logic or evidence, make the hearing process look like Kabuki theater, or a show trial.  It’s not intended to raise issues, find facts, sift evidence, or air serious disagreements.  Instead, it’s purely a theatrical production, with a pre-scripted outcome, intended to convey the impression of investigation, inquiry, and debate.

In the scheme of things, manipulation should be one of the easier things to regulate and deter in financial markets.  Nonetheless, Congress and various alphabet soup regulatory agencies (GFA, CEA, SEC, FERC, and probably soon, FTC) have made a complete botch of it for going on 87 years now.  (Yeah, I know.  But I’m feeling generous today.)  Yet we’re supposed to have confidence that that same Congress and same array of regulators (plus some more) have the knowledge, competence, and incentives to legislate and regulate much more complex and arcane aspects of the operation of the financial markets (e.g., clearing, “excess” speculation, product design).

Just remember the three big lies.  The check is in the mail.  I’ll respect you in the morning.  And the biggie: I’m from the government, and here to help you.

April 2, 2009

Accounting Follies & Moral Hazard

Filed under: Economics,Financial crisis,Politics — The Professor @ 10:21 pm

FT Alphaville discusses the FSAB’s decision to relax mark-to-market requirements for banks for assets for which the market is inactive, or for which prices are distorted by numerous fire-sales, and the implications of this for bank stocks.  I think this is a bad idea, but being pressed for time, for now I will merely repeat the comment I left on the FT post:

The reason that accounting rules should influence one’s decision on whether to buy banks is different from those you mention in this post. The value of bank stocks right now, especially the dodgy ones, derives from the government put (either formally, through deposit insurance, or informally through the too-big-to-fail bailout possibility). The value of this put is greater, the longer banks have the opportunity to survive, and potentially gamble their way out of insolvency, or catch a break from an unexpected upturn in the economy to save them from receivership. Obfuscating the value of assets, and giving banks more discretion over their valuation through choice of accounting treatment, extends the life of that option, and makes it more valuable.  

So, to the extent you believe that accounting rules or other mechanisms will permit insolvent banks to extend their lives, and exploit volatility (and indeed, increase volatility) and the government put, then yes, it may be a time to buy banks. Sadly, the banks’ shareholders’ gain is not a social gain, as it is achieved at the expense of those underwriting the put. Namely, me and other American taxpayers.  

We saw this before, in the S&L crisis, when in the mid-80s “regulatory capital” and other accounting dodges permitted (a) insolvent institutions to survive, and (b) Congress to avoid appropriating the money to address the problem when it would have been cheap to do so. We all know how well THAT turned out. A manageable, relatively inexpensive problem metastized into a barely manageable, very expensive one. But, those who cannot remember the past etc., etc.

Willem Buiter weighed in a few hours later with similar remarks:

Under FAS 157, the FASB’s standard on fair-value measurements, holders of financial assets recorded at fair-value must state what these values are based on. Three levels of information or assumptions are distinguished, corresponding to   how “publicly observable” the information is. In level 1, the value of an asset or liability stems from a quoted price in an active market. In level 2, it is based on “observable market data” other than a quoted market price. In level 3, which often applies to asset valuations in illiquid markets or in “distressed” sales (or “fire sales”), fair value can be determined only by inputs that cannot be observed or verified objectively.   Typically this means prices based on internal models or management guesses.

Basically, the new guidance allows banks to shift a whole load of toxic and impaired securities from level 2 to level 3.   Up till now, a frequent source of level 2 information were prices achieved by competitors’ asset sales to help determine the fair-market value of similar securities they hold on their own books. Banks are now allowed to ignore prices achieved in competitors’   asset sales when these transactions aren’t “orderly”.   This includes transactions in which the seller is near bankruptcy or needed to sell the asset to comply with regulatory requirements.   This is vague and broad enough to drive a coach and horses through fair-value accounting for most imperfectly liquid assets.

Leaving the valuation of illiquid securities to managerial discretion will lead to systematic and systemic overvaluation.   Banks with significant amounts of toxic assets and plain bad assets on their balance sheet have lied, lie and continue to lie about what they have on their balance sheets.   This has now been made easier.   No wonder bank stocks rose and bank credit default swap rates declined.   Reported asset values will be boosted.

Analysts estimate that, now that banks can mark toxic assets using their own models (which are private information) rather than what they would fetch on the open market, quarterly profits at some banks could be boosted by up to 20 per cent.

. . . .

The official excuse for this egregious pandering to the interests of zombie bank managers and unsecured creditors is that mark-to-market (or fair value) accounting is to blame for exacerbating banks’ capital problems and causes exacerbation of pro-cyclical and potentially systemically destabilising   detrimental feedback loops between lack of market liquidity, distress asset sales, mark-to-market, margin calls, falling asset prices and lack of funding liquidity.

That argument makes no sense.   It is clearly desirable that regulators and supervisors exercise regulator/supervisory forbearance as regards the implications of mark-to-market for regulatory capital requirements and for any other regulatory requirements when asset markets are distressed and illiquid.   They should do the same when asset markets are perfectly liquid but subject to speculative bubbles.

But  given  micro-prudential regulatory forbearance as regards mark-to-maket capital losses incurred on illiquid securities, and  given  sensible macro-prudential responses by regulators, monetary and fiscal authorities when securities markets are illiquid, there is no earthly reason for deliberately lowering the informational content and quality of published corporate accounts.   This impairment of the informational content of the corporate accounts will be the inevitable consequence of replacing valuation using market prices (even illiquid market prices) with the judgment of the deeply conflicted managers of these corporations. Investors will be worse off.   Corporate governance will suffer.   Accountability of corporate executives and boards will diminish.   And, because mark-to-myth is likely to prevent necessary corrective measures from being taken, or at least to delay them, the FASB’s encouragement of marking-to-myth is likely to increase future financial instability.


It really is wonderful how the US political and regulatory establishment is riding out in support of its wonky banks.   First, the Treasury Secretary Timothy Geithner proposes a toxic and bad assets purchase scheme (the PPIP or Public-Private Investment Program) which subsidizes the private parties in the public-private partnerships   bidding for the toxic assets by leveraging the private and public equity involved in the bids through non-recourse loans or guarantees.   This permits – indeed encourages – private bidders for toxic assets to make bids far in excess of their estimates of the fair value of these assets.   Their rents can then be split between the private bidders for the assets and the banks selling them.

Second, in case even this isn’t good enough, banks that would rather not sell these toxic or bad assets, even at these inflated prices, can avoid pressure (from the regulators or from shareholders) to sell by marking-to-model (that is, marking-to myth) the assets rather than marking to market.   This gives the management of the bank more time to ‘gamble for resurrection’ at the expense of the shareholders and other stakeholders, including the tax payers.   Most importantly, banks with large amounts of undeclared crud on their balance sheets will act like zombie banks, engaging in little new lending or new investment in the real economy.   While their managers sit, wait and pray for a miracle, intermediation between households and non-financial enterprises continues to suffer.

The G20 have made many pious statements about the need to recognise the losses that have been incurred, on and off the balance sheets of banks and shadow banks, and to ensure that the dead hand of the overhang of past losses does not act as a tax on and deterrent to new lending and borrowing by banks.   Yet the primus inter pares in the G20, the USA, decides to give its banks another large fig leaf behind which to hide their losses and gamble for resurrection.   This continues and prolongs the zombification of most Wall Street banks.

The FASB, like the rest of the American regulatory and standards-setting establishment, appears to have been captured lock stock and barrel by the vested interests of the large Wall Street zombie banks (management, shareholders and unsecured creditors).   This may well have been another example of cognitive regulatory capture, like that which has afflicted the SEC and the Fed.

No doubt the IASB will wimp under also, and promulgate a new ukase permitting European banks also to substitute managerial judgment/wishful thinking for market valuation. Our accounting standard setters are making terrible and very costly choices.   Paraphrasing Churchill: mark-to-market accounting is the worst accounting principle in the world, except for the others.

Buiter’s capture point is an excellent one, and one that I have been planning to write on for awhile.  Maybe this weekend will provide the time to do it.   I note merely in passing, that the PPIPs program is also severely tilted in favor of big, politically influential real money managers, e.g., BlackRock and PIMCO.  I wonder how that happened.

In related news, Bloomberg reports that Federal regulators are considering forcing major banks to write down assets by $1 trillion:

U.S. regulators may force Bank of America Corp.,  Citigroup Inc.and at least a dozen of the nation’s biggest financial institutions to write down as much as $1 trillion in loans, twice what they’ve already recorded, based on Federal Deposit Insurance Corp. auction data compiled by Bloomberg.

Banks failing Federal Reserve evaluations of loans this month may be ordered to make sales worth as little as 32 cents on the dollar, according to FDIC data. That would be less than half of the 84 cents on the dollar the Treasury Department suggested was a possible purchase price. Some of the bank- insurance agency’s auctions brought 0.02 cent on the dollar.

Regulators are apparently aware that the Achilles Heel of the Geithner plan is the optionality it extends to banks:

“If there’s an issue with the program, it’s going to be trying to get banks to sell assets,” FDIC Chairman  Sheila Bair  said in a speech the same day at the Isenberg School of Management of the University of Massachusetts in Amherst.

“If I have concern, it’s the pricing may not be where seller and buyer are willing to meet,” she said.

Any standoff between investors and banks over loan prices may scuttle Geithner’s plan to segregate non-performing assets and restart lending, said  Bob Eisenbeis, chief monetary economist with Vineland, New Jersey-based Cumberland Advisors and a former Atlanta Federal Reserve Bank research director.

‘Really Bad Stuff’

“It’s hard to believe that the really bad stuff that’s causing all the problems are going to be offered for sale,” Eisenbeis said. “The institutions won’t want to sell them if they get a true price, because their capital would take too much of a hit.”

This is an advance, and one wonders whether Bair, Geithner and others knew it all along, and planned a pincer movement–establishing PPIPs as a mechanism for buying these assets, and then hitting the other flank by using regulatory pressure to force banks to sell.  

But why the indirection?  Is this politically driven?  That is, was this strategy of the “indirect approach” (to borrow a phrase from military writer Liddell Hart) chosen over the “direct approach” (i.e., good bank-bad bank in some variant) because the judgment was made that the latter would crumble in the face of fierce bank resistance?  Is this driven by an assessment of regulatory capabilities, i.e., a consideration of what regulatory weapons the FDIC has at its disposal?  Is it primarily driven by a recognition that Congress would never fund the direct approach, so stealth bailouts are required, and regulatory pressures are necessary to make the purportedly “voluntary” Geithner plan work?  

I don’t know the answers to these questions.  I would prefer the direct, transparent approach.  The indirect, apparently disconnected approach could be attributed to canny strategizing, but it could also indicate intellectual confusion, ad hoc decision making, extemporization, and the dysfunctional consequences of a dysfunctional Congress.  

I would also note that there is incredible tension and inherent contradictions in much of the policymaking.  The FASB action completely undercuts the Geithner plan–as a standalone initiative.  If, in fact, the Geithner plan is part of a pincer strategy in which the government will force banks to participate by forcing writedowns, the FASB action raises the level of government force required to achieve that end.  

My main concern about these indirect, opaque plans to deal with banks is related to a point I made in my FT comment.  Namely, we have been here before, in the S&L mess in the 80s.  Congressional malfeasance then made a bad problem into a horrific one.  Congressional failure to grasp the nettle, and fund a reasonable cleanup of the S&Ls led regulators to resort to all sorts of indirect “fixes” that only allowed the problems to metastasize.  

The most charitable interpretation of the administration’s actions is that it recognizes that the current Congress is likely to commit malfeasance on even a grander scale, and hence feels compelled to disguise bailouts by making vast commitments, unfunded at the present (most importantly, the commitments inherent in non-recourse lending), but which will effectively force Congress to provide funding in the future when the bills come due.  

I would prefer a more direct, honest, and transparent approach.  It would provide confidence that the true problem is understood and is being addressed, whereas the present course leaves considerable room for doubt.  But, being charitable to the administration requires one to believe that even it views Congress as incorrigible, irredeemably unreliable, and counterproductive.  That is perhaps the most sobering, no, disturbing, possibility of all.  


More Poses

Filed under: Military,Politics,Russia — The Professor @ 10:02 pm

Dale Herspring and Roger McDermott have a long new piece on the Potemkin Russian military (available on JRL).  It is quite extensive, and too long to quote in its entirety, but the intro and summary convey the essence:

In his March 17, 2009 speech to Russia’s top military brass, Russian President Dmitri Medvedev raised the specter of a strong and robust Russian military.  The fact is that while  Russia  is undergoing a major reform of its armed forces, and beginning to pump money into it, it will be several years, 2020, according to many Russian officers, before the Russian armed forces will be equipped with modern weapons.  The reality is that the Russian military is in no position to threaten anyone.  By their own admission, Russian generals view the war in Georgia as a “disaster.”  Russia won, but only by using outdated weapons and equipment and the kind of frontal military attack that was more reminiscent of World War II, than of the modern type of warfare.  In short, Medvedev’s effort to play the military card was nothing more than an effort to gain a diplomatic advantage by pulling the wool over the West’s eyes.

. . . .


We have no doubt that Serdyukov is serious about reforming the Russian military.  Furthermore, while we are aware of the unhappiness of Russian officers vis-a-vis many of his actions, there is no sign to date that there is much the officer corps can do to stop him from making changes.  Besides, it is clear to most outside observers, that while one many decry Serdyukov’s personality in dealing with military officers, the changes he is making are badly needed but will be years in making an impact on the army’s combat efficiency.

From a policy standpoint, the foregoing suggests that Medvedev’s references to a military build-up are a bluff, used to convince the West that it is in its interest to make a deal with the Russians.  While we take no position on policy, we think it is important to emphasize that the Russian military build-up should not be seen as a major factor in negotiating with the Russians.

In between, Herspring and McDermott discuss the colossal, enervating corruption that pervades the Russian defense establishment; Serdyukov’s efforts to fight it; and the uniformed military’s ferocious opposition.  They also examine the dilapidated, and still declining, state of Russian military manufacturing capability; the problems with weapon design; the poor performance in Georgia.  Overall, a very negative assessment on virtually every major dimension.  

In a recent Heritage Foundation report on Russia and Eurasia, Stephen Blank presents a more favorable appraisal of current Russian capabilities, and their prospects for improving them.  He argues that the Georgian War demonstrated the ability of the Russian General Staff to conduct combined arms operations, to achieve strategic surprise, and demonstrate strategic mobility.  He also warns of Russian cyberwar capabilities, the destablizing potential of the Iskander missile, and its overwhelming military advantages vis a vis the CIS countries.  Most importantly, he argues that the current Russian government “by its very structure” is prone to military adventurism, and is intent on stoking hostility with the West and attempting to intimidate Europe.  

Perhaps the most interesting part of his analysis is his statement that 40-50 percent of total Russian defense expenditure is lost to graft.  Professor Blank tells me that other estimates place the amount of theft north of 50 percent.  That is a truly impressive figure, and perhaps suggests reasons (in addition to delusions of imperial grandeur) why Medvedev and Putin are so intent on boosting military expenditure even in the face of a daunting economic and budgetary situation: namely (a) it’s one of the last places to make money the old fashioned way, given the erosion of other opportunities for graft and rent seeking given the decline in raw material prices, and (b) it’s necessary to keep the brass (a potentially serious threat to the regime) happy.  (That is, maybe the uniformed leadership is less interested in shiny new military hardware, than what they can skim while pretending to procure shiny new military hardware.)

Lastly, Paul Goble has an interesting piece on the failure of the military to make any real progress towards its stated goal of creating a professional, volunteer military, to replace its 19th-century/early 20th-century style mass conscription army:

 A  major reason that the Russian military is having to draft so many soldiers this spring is that the uniformed services are failing to meet their quotas for recruiting professional soldiers, a shortcoming that experts say reflects both the low salaries they are now offered and the low status of the profession Moscow would like to recruit them to.

The Moscow media have been full of stories about why the spring draft is so large, with most commentators pointing to the change in the length of military service for draftees, and why this round is so filled with problems, ranging from the declining size of the draft pool to the difficulties of the current economic situation.  

But in comments this week, Sergey Krivenko, the coordinator of the Social Initiative ‘The Citizen and the Army,’ argues that an even more important explanation for the size of the draft is the military is the failure of the armed services to recruit and retain professional soldiers (

If the armed forces had done so, he says, the number of young men needed to be drafted this round would be 264,000 rather than the 305,000 the military now seeks. The military says there are now 207,000 contract soldiers, but Krivenko’s comments suggest that even if that is the case, it is less than the military planned for.

At the end of 2007, the military rights activist says, there were 125,000 slots for such professional soldiers, but only 99,000 of them were filled, a reflection of many things but particularly the relatively low salaries that the Russian military offers the group around which it hopes to build its future.

At present, according to the general staff, professional soldiers in the army receive from 11,300 to 16,000 rubles (300 to 450 US dollars) a month while professional sailors receive only slightly more, 16,000 to 18,000 (450 to 550 US dollars), amounts that are unlikely to attract many even during the current economic crisis.

In addition to the low salaries, Krivenko adds, “conditions of service are [so] poor” that “contract soldiers simply are running away. And as a result, units that had been scheduled to be staffed entirely by professional soldiers are now being shifted back to a mixture of professionals and draftees, a composition that can prove combustible.  

Add this to stories last month about the military’s decision to cease (or at least postpone) its efforts to train professional NCOs at several military schools due to the very low skill level of those who volunteered for the program (e.g., inability to do elementary school mathematics), and you have a very bleak picture of the prospects for the development of a professional, 21st century military force.  So, young Russian men can look forward to a continuing, and indeed increasing, reliance on conscription (increasing, due to the reduction in the length of service, and the declining population of healthy, mentally fit, military aged men), and the continuation of  dedovshchina  in the barracks.  Lord of the Flies,  military version.

There is a tension between the Blank view, and that of Herspring, McDermott, and Goble.  The latter are likely far less concerned about the Russian military than the former.  I would say that Blank is right about intentions.  Moreover, despite its evident dysfunctions and deficiencies, well described by Herspring, McDermott, Goble, and others, the Russian military is still dominant in the former Soviet space.   I therefore come away from reading these sources, and many others besides, with a mental picture of a shambolic military that is still sufficiently powerful to inflict rapid defeat on the small states that surround it (many of whom also have shambolic militaries), and which has the willingness to do just that.

SWP on Trial in the 7th Circuit

Filed under: Commodities,Derivatives,Economics — The Professor @ 5:06 pm

OK, that’s hyperbole.   But my work in the case in Josef A. Kohen, Breakwater Trading LLC and Richard Hershey v. Pacific Investment Management Co. (“PIMCO”) was the focus of some attention in the argument heard before a 7th Circuit panel headed by the formidable Judge Richard Posner.   Here’s an MP3 of the hearing. Defendant PIMCO had appealed class certification in the case, and the hearing related to the question of whether Judge Guzman’s (the trial judge) decision to certify should stand.

Listening brought back memories of my grad school days, specifically the Economics of Legal Organization Workshop at Chicago.   Posner, Stigler, Becker, Telser, Peltzman and other heavyweights would sit in the first row.   Usually the speaker would utter perhaps two sentences, and then one of the front row crowd, and often Posner in particular, would jump in with a question expressing extreme skepticism, criticism, or incredulity.   That’s what happened to PIMCO’s lawyer.   Two sentences, and up pipes Judge Posner with a very, pointed, shall we say, question.

I’m biased, and an amateur observer of these sorts of things, but overall I think it went pretty well for the good guys.

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